Perspectives on where our world is heading from a vantage point in Denver, Colorado.

23 March 2011

Feds Take Aim At Investment Banks

The National Credit Union Administration is a federal regulatory institution for credit unions roughly analogous to the FDIC for commercial banks. The credit union industry is structured in two main tiers. As the Wall Street Journal explains today:

The wholesale credit unions, also known as corporate credit unions, are at the heart of the nation's credit-union system. They not only invest customer deposits but also provide services such as check clearing for nearly 8,000 "retail" credit unions—member-owned cooperatives that act somewhat like banks for firefighters, teachers and other workers who have something in common. Such customers have a total of about $680 billion in deposits at credit unions.

In reality, the strength of the tie between what customers of credit union members have in common has declined for years. For example, I am a member of the Security Services Federal Credit Union, despite the fact that the only paying jobs that I have ever held in my life have been as a newspaper delivery boy, as a freight unloader in a university kitchen, as a tutor, as a math homework grader, as a continuing education instructor, as a professor, as a reporter and as a lawyer, none of which rightly qualify as security services unless you include the occassions when I've acted as bouncer at law firms where I have been employed. But, they remain member owned and tend to be more conservative in their lending and investments than commercial banks.

The NCUA put five wholesale credit unions into receivership as a result of the financial crisis. The Wall Street Journal, summed up the impact of those receiverships, three of which took place in September of 2010, and the other two of which were earlier.

Bad bets on mortgage-backed securities have now killed five of the nation's 27 wholesale credit unions since March 2009. The federal government, which now controls about 70% of the total assets at such credit unions, said the surviving institutions will be reined in so that they take fewer risks with their investments. . . . Members United Corporate Federal Credit Union in Warrenville, Ill., Southwest Corporate Federal Credit Union of Plano, Texas, and Constitution Corporate Federal Credit Union, Wallingford, Conn., which had a total of $19.67 billion in assets as of July, were taken into conservatorship by federal regulators. . . . Since the start of 2008, 66 retail unions have failed, compared with more than 290 banks or savings institutions. . . . Last year, regulators seized the two largest wholesale credit unions, U.S. Central Federal Credit Union, based in Lenexa, Kansas, and Western Corporate Federal Credit Union, San Dimas, Calif., after finding their losses were much larger than previously reported.

Losses on the mortgage-backed securities held by the five seized credit unions are expected by regulators to total about $15 billion. Wiping out the capital of the failed institutions will cover a chunk of those losses. But the remaining $7 billion to $9.2 billion eventually will be passed along to the nation's 7,445 federally insured credit unions in the form of future assessments.

The total number of failed banks and S&Ls has now risen to more than 350.

The $50 billion of mortgage backed securities bought by the wholesale credit unions which placed into receivership are now worth about $25 billion. WesCorp, which had 74% of its investments in mortgage backed securities has suffered a 31% on its mortgage backed security portfolio, the other four wholesale credit unions suffered losses of 10% to 16% on their mortgage backed securities portfolio which made up 31% to 57% of their respective portfolios of investments.

Of hundreds of bonds inherited by the NCUA in its rescues of wholesale credit unions, many were packed with subprime mortgages, interest-only loans or mortgages with other risky characteristics such as not requiring income verification. The mortgage-backed securities often carried Triple-A credit ratings at first. Many now have junk ratings.

Now, the NCUA and other federal agencies stuck with the bad loans are threatening suits to strike back at the investment banks that overhyped these mortgage backed securities:

The NCUA is accusing Goldman Sachs Group Inc., Bank of America Corp.'s Merrill Lynch unit, Citigroup Inc. and J.P. Morgan Chase & Co. of misrepresenting the risks of the bonds to wholesale credit unions. . . . agency officials recently issued an ultimatum to several firms that churned out the bonds: Either refund every dollar spent to buy the bonds when they were issued or face lawsuits seeking to recover the money. In a securities filing this month, Goldman said the NCUA "has stated that it intends to pursue. . . on behalf of certain credit unions for which it acts as conservator" claims that offering documents for certain securities Goldman sold "contained untrue statements of material facts and material omissions."

The NCUA claim is the classic securities fraud 10b-5 suit. The NCUA is claiming that the investment banks had to lie in very specific disclosure document in order to sell their bonds.

But, the economics involved in a securities fraud suit against an investment bank based on bond issuances are very different than the economics involved in the more typical securities fraud suit against a corporation brought by shareholders of that corporation based on stock issued long ago and were trading in the secondary market when the person who is suing bought them.

In a suit by a bondholder, the situation is very similar to an ordinary fraud suit where someone selling something lies about it to make a sale in exchange for immediate payment in which the seller has a direct and immediate financial interest. And, the pot of money from which recovery is sought is different from the one owned by the people bringing the suit.

The FDIC, the Treasury and the Federal Reserve, each of which holds similar securities acquired in the course of the bailout for which similar representations were made could bring similar suits.

[T]he Federal Deposit Insurance Corp.'s board has authorized the filing of lawsuits seeking to recover more than $3.5 billion from officers and directors at failed U.S. banks.

Last week, the FDIC accused the wives of Washington Mutual Inc.'s two top executives at the time of the big thrift's 2008 collapse of illegally moving cash and houses into trusts to shield the assets.

The executives called the suit seeking over $900 million baseless. . . .

Last year, the FDIC took over as plaintiff in a suit filed by Riverside National Bank of Florida, a bank in Fort Pierce that, before failing in April, had stuffed its portfolio with 27 collateralized debt obligations, or slices of bond pools. Riverside accused more than a dozen firms of misrepresenting the CDOs' value. At the time the FDIC stepped in, it owned parts of over 250 CDOs bought by small banks that subsequently failed.

Of course, investment bankers were the only one's at fault:

In November, an audit by the NCUA's inspector general concluded that the management and board of one wholesale credit union, called Western Corporate Federal Credit Union, or WesCorp, didn't properly manage the risk of its portfolio and bought too many mortgage securities. . . . The inspector general's review didn't analyze the possible role of underwriters, issuers or credit-ratings firms.

It isn't entirely clear from the newspaper report whether the investment banks were acting and underwriters or issuers in these sales. Credit ratings themselves are considered "opinions" which do not give rise to fraud liability, even though most bond traders rely on those ratings almost completely to the exclusion of prospectuses, and even though a triple-A rating was in fact completely inappropriate for securities that were as risky as the entire class of mortgage backed securities that were issued actually were in hindsight.

Establishing that facts in the prospectus were false or that facts existed that were omitted from the prospectus, and that those facts had a material impact on the value of the securities, is generally straightforward legally now that investigations have revealed what when wrong with these securities.

The unknowns in suits against investment banks are establishing that the investments banks a the proper parties to sue, rather than special purpose companies set up to issue the securities, because securities laws do not generally recognize "aider and abettor" liability for securities fraud. And, the party bringing the suit also has to establishing "scienter" at the time that the prospectus containing material fact or omitting material facts was prepared. In other words, it isn't enough to show that a statement included a false statement or omitted a material statement, the suit has to show that the company making the statement knew at the time that it was stating something that was untrue and material, or omitting a fact known to be material.

In defending the suits, the investment banks can either claim that it didn't know about the ugly details, or that they believed that the facts were not material because features of the bonds like guarantees from loan originators and credit default swap derivatives made problem with the underlying bonds irrelevant, and nobody realized that "counterparty risk" in these guarantees was as serious as it actually turned out to be in hindsight.

If a court finds that they lied, the investment banks are on the hook and their newfound post-financial crisis profits could evaporate. But, if a court finds that they weren't aware of the problems with their prospectuses, then they are off the hook. Post-financial crisis investigations which seem to show that there were insider communications showing that insiders at major investment banks knew that mortgage backed securities were really junk weaken the case of the investment banks on the merits, if they are not mere "aiders and abetters." Revisions to the bankruptcy code made in 2005 also makes it much harder for investment bankers found to have lied to protect their assets from those who prevail in securities fraud lawsuits.

Moreover, if one federal agency prevails in a securities fraud suit from a particular bond issuance, and appellate courts set precedents that clear legal obstacles to that theory of recovery by affirming those wins, other federal agencies and private bondholders who took losses in the same or similar deals can walk into court using the doctrine of collateral estoppel to apply the first winner's success to their own cases, leaving little more to be proved. As a result, there are huge incentive beyond those in these particular NCUA lawsuit for the investment banks to settle the cases to avoid setting a precedent to could be applied in many other cases.

Thus, it is very likely that the investment banks will have to pay record settlements that reduce taxpayer and innocent investor losses at the expense of the investment banks before the aftermath of the financial crisis is complete.

1 comment:

Nice information! The role that an investment bank plays sometimes gets overlapped with that of a private brokerage house. The usual advice of buying and selling is also given by investment banks. Thanks a lot.